Here’s a sobering fact: The vast majority of investors in mutual funds actually manage to get worse returns from their funds than the funds themselves generate and report. Let that little nugget sink in a moment. How can this be? We can’t help trying to “time” the market and so jump in and out; almost always at the wrong times.

Here’s what Warren Buffett has to say about this:

“The Dow started the last century at 66 and ended at 11,400. How could you lose money during a period like that? A lot of people did because they tried to dance in and out.”

Oh, sure. Occasionally we can, and Oh My what a heady feeling it is when it works. It is incredibly seductive. Picking a stock that soars is an intense and addictive high. The media and internet are filled with “winning” strategies that feed on this delusion.

Last year I spotted a trend and made 19% in four months on the five stocks I choose. (Sigh. I still have this addiction.) That’s almost 60% annualized. This while the market was flat for the year. That’s spectacular, if I do say so myself. It is also impossible to do year after year.

Even slightly beating the Index year after year is vanishingly difficult. Only a handful of investors have been able to modestly outpace it over time. Doing so made them superstars. That’s why Warren Buffet, Michael Price and Peter Lynch are household names. That’s why I don’t let my occasional win go to my head. That’s why I let Index Funds do the heavy lifting in my portfolio.

Actively Managed Stock Mutual Funds (funds run by professional managers as opposed to Index Funds) are a huge and highly profitable business. Profitable for the companies that run them.* For the investors, not so much.

So profitable are they, there are actually more mutual funds out there than there are stocks. You read that correctly. Yeah, I’m amazed too.

There is so much money at stake, investment companies are forever launching new funds while burying the ones that fail. The financial media is filled with stories of winning managers and funds, and advertising from them. Past records are analyzed. Managers are interviewed. Companies like Morningstar are built around researching and ranking funds.

The fact is only 20% of fund managers will beat the Index over time. 80% will fail. 100% of them will charge you high fees to try. There is no predicting which will be in that rarefied 20%.

Every fund prospectus carries this phrase: “Past results are not a guarantee of future performance.” It is the most ignored sentence in the whole document. It is also the most accurate.

Here’s little “trick” the mutual fund companies employ. When one of their funds under-performs they’ll simply quietly close it and fold the assets into something doing better. The bad fund disappears and the company can continue to claim its fund are all stars. Cute.

There’s lots of money to be made with actively managed funds. Just not by the investors. Want to hear me rant more about this? Here you go:

Imagine you’ve just spent a few hours reading all pithy posts here on jlcollinsnh. (As well you should!) Richly deserving of a reward you crack open a bottle of your favorite brew and pour it into a nice chilled glass.

If you’ve done this before you know that if you carefully pour it down the side you’ll wind up with a glass filled mostly with beer and a small foam head. Pour it fast and down the center and you can easily have a glass with a little beer and filled mostly with foam.

Imagine now someone else has poured it for you, out of sight, and into a solid mug you can’t see thru. You have no way of knowing how much is beer and how much is foam. That’s the stock market.

See, the stock market is really two very different things:

1. It is the beer: The actual operating businesses we can own a part of.

2. It is the foam: The traded pieces of paper that furiously rise and fall in price moment-to-moment. This is the market of CNBC. This is the market of the daily stock market report. This is the market people are talking about when they liken Wall Street to Las Vegas. This is the market of the daily, weekly, monthly, yearly volatility that drives the average investor out the window and on to the ledge.

This is the market that, if you are smart and want to build wealth over time, you will absolutely ignore.

When you look at the daily price of a stock it is impossible to know how much is foam. This is why a company can plummet in value one day and soar the next. This is why CNBC routinely features experts, each impressively credentialed, confidently predicting where the market is going next – while contradicting each other. It is all those traders competing to guess how much beer is actually in the glass, and how much is foam.

Over time, it is the beer that matters.

It is the beer that is the real, operating, money making underlying businesses beneath all that foam and froth that relentlessly drives the market ever higher.

Understand, too, that what the media wants from these commentators is drama. Nobody is going to sit glued to their TV while some rational person talks about long-term investing. But get somebody to promise the Dow is going to 20,000 by year’s end or, better yet, is on the verge of careening into the abyss, and brother you’ve got ratings!

But it’s all just so much noise and it doesn’t matter to us. We’re in it for the beer!

Next time we’ll talk about that big, ugly event.

Addendum:

*In addition to underperforming Index Funds, actively managed funds cost more, and those costs have a very serious and negative impact on your results. My pal Shilpan has a great post on this: That Mutual Fund is Robbing Your Retirement

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Comments

Nice take on the market psychology Jim. You’ve hit the nail on the head with the facts on mutual funds. I think people who invest in mutual fund without giving much thought are worst than those who try to actively manage their portfolio by picking stocks.

Jim-
What’s a “tax-managed” fund?
I have some Vanguard balanced funds, and I’m wondering what that means.
I’ve been testing your theory. I have half my investment in a managed fund, half in an index fund. So far, I’m ahead on the managed, so I figure it might be time to get out and go index. Overall, the difference doesn’t seem to be worth the extra cost.

most actively managed funds do a lot of trading in their effort to try to out-pace the Index. Problem is, those trades are taxable events for the fund shareholders creating tax liabilities that may not be expected or wanted.

a tax-managed fund seeks to limit its trading and thereby its taxable events for shareholders.

Because Index funds buy and hold all the stocks in an index they are, by definition, tax efficient.

Good luck with your test. a big advantage Index funds have is their low cost. Managed funds charge higher fees and that is a never-ending drag on their performance.

Great post, Jim. I’ll take my nice Belgium beer with little foam, sit back and enjoy. It’s important for people to continually to pound it into their heads that at some point in time, they are going to loose a lot of money in the stock market, it’s how it goes, but you have to be patient and ride out the tough spots to gain that money back. It’s counter intuitive to how our fight/flight brains are wired, so you have to show discipline and stay the course.
You should consider doing a post on the craziness that is Bitcoin right now. People are thinking this is the next big thing, and people are foolishly (IMO) looking at it as an investment. The cyrpto-currency has its pros and cons, but it’s not going to replace the USD or any other currency for that matter, just potentially become a new contender in the currency game. It has to be less confusing to the public for it to be widely accepted, which in its current state, it is not.

While it might not always show, I try to write only about those things I actually know and understand. 😉

I will say one of the reasons I tend to hold minimal cash is that all currencies are somewhat imaginary. That is, any value is a function of mutual agreement subject to constant change. I prefer owning pieces of dynamic, striving businesses = stocks = VTSAX.

One thing I don’t get: How is it that supposedly MOST people perform worse than the corresponding index share market?

Let’s say you are right and one can not predict shares that outperform the market, – is it then not that by pure chance 50 % of us would perform better, 50 % would perform worse, – i.e. would there not a normal bell curve type distribution around the mean?

This is of course different if I pay fees for a managed fund, or if I pay lots of fees for trading, – but if we take that out of the equation for this question, – if it just came to me deciding to pick my own stocks out of a basked (let’s say the Dow Jones), – would my chances not have to be 50 : 50?

I saw this on your Q&A II and I don’t know if I’m interpreting the question correctly and don’t want to fault your answer, but… I think the question is how is the market not a zero-sum game (before fees of course)? I’m sure I’m missing something, but market timing alone doesn’t seem to explain it on a whole. It seems intuitive that for everyone that buys high and sells low there would have to be someone buying low and selling high. So maybe it’s more a matter of equity distribution, when stocks are high the stocks get spread thin to more people because people are bad a timing stocks, and then when they are low fewer people buy them but get more of a slice. Sorry, too many rambling comments after my afternoon coffee…

Yes, sorry, game was a bad choice of words, and I get why the economy grows. So maybe zero-sum game doesn’t quite convey what I meant. I was trying to say zero-sum with respect to the overall market. If market indices representing the mean, to say that most people lose money in the stock market implies that the median return is much less than the mean. What explains that? Intuitively one might think that for every person who times the market wrong and sells low, they must be selling to someone so that second person timed the market correctly and you end up with one person losing money and one person making money. Then across the millions of transactions that define the stock market you might end up with a normal distribution with regards to gains and losses relative to the market, sort of like the distribution you’d expect if you had millions of people flipping coins over and over again. But then I realized it only takes one person who timed the market correctly to buy up shares from many people who timed it incorrectly, so the distribution isn’t a nice normal bell… Or is my understanding of the stock market / math still way off?

Hey Chris, Jim’s delayed reply was definitely my fault so I apologize for that. He emailed me to ask if I’d take a stab at replying to your comment and I said I would but I’m only making it over here now.

Luckily, Jim chimed in with a great response (no big surprise there) so hopefully that answered your question.

I wrote an article about some of the cognitive biases that cause us to make bad investing decisions so feel to check that out for a few more reasons why most people underperform the market.

Maybe I’m just weird, but when I pour a beer I aim straight for the bottom because I like the foam 😛 I just realized today when talking to a friend about investing that we’ve only ever sold stocks once, to make the down-payment on our house (aside from 401k rollovers or small allocation adjustments which I wouldn’t exactly classify as selling). As a matter of fact, I was referencing this very post. We are both pretty boring investors and were discussing how it’s hard to talk investing with most people who are all “market timing” this and “daily fluctuations” that. They definitely don’t want to be told how they are playing a zero sum game at best (before fees) and are really just gambling in a casino they don’t own at worst. Anyhow, I was mentioning an amazing blog I read that has a great explanation about how crazy it is that people lose money in the stock market despite the fact that the market always goes up 😉

I second that. 10 years ago I picked some Vanguard funds for my 401k simply because I liked the name Vanguard better than the others on the list of available funds. Totally ignored it and looking at the growth, I would kill to have had that in my after-tax brokerage account.

I ran across a strategy that seems like it should beat buying-and-holding and indexing. I’m sure there must be a flaw somewhere in the logic, but I can’t find it. I was wondering if you could point it out for me. Even if it did work, I expect the effort:reward ratio would be much too large for it to be practical for me to do it, but I don’t see why it shouldn’t work in theory.

The basic point is that the market is not, actually, rational. People assume it is, but humans do a large amount of the trading, and humans make mistakes. If they didn’t, there would be no foam and you’d just have beer, and the title of this blog post would be wrong. In some cases, you can tell when these mistakes are happening and take advantage of them in the short term.

For example, suppose you see than company XYZ has crashed a lot today. You look into it, and there are rumors that they were cooking their books and will be facing severe penalties. You look into the rumors a bit more, and you see they are completely unsubstantiated. In that case, you can expect that XYZ has very little or perhaps a negative amount of foam on top, and you should buy it; eventually the realization that the rumors are false will hit the general public and it will go up to about where it was before. This can happen in spite of rational professionals because the rational professionals aren’t always paying perfect attention to every stock, might be looking at more long-term strategies, might have algorithms responding to the bad news by selling before the humans have a chance to look into the details, etc.

This is just one example; there are other cases when some research can tell you that the public is mistaken about some company in the short term. This takes a lot of luck in noticing stocks trading well below their usual values, effort in determining why, and further luck in being able to identify that the reasons are bogus. However, it is sometimes possible, and in those cases it seems like a good strategy is to buy low and sell later when the market has stopped being so irrational about this particular stock.

What is wrong with this strategy? If you keep your money in index funds except when you identify an irrationality in the market, it seems like you can only fail if you are wrong about your identified irrationality (in which case you should have just been more careful and only done this when you were sure), the gain is not worth the various fees from buying and selling shares (in which case you should have been more careful), or the market remains irrational longer than you expect.

What am I missing? This strategy does depend on an identifiable short-term irrationality and in theory those shouldn’t occur, but in practice they can. Is it just that the effort involved would not be worth it to most people?

Regarding the investment strategy, in both those posts, please also note the policy of not commenting on such things under the title: “The investment ideas of others:”

That said, given your help, let me offer these few comments.

–The strategy you outlined falls under the category of it sounds easy but isn’t. Kinda like the whole idea that outpacing the index should be easy. All you have to do is not buy the dogs, right?

–Basically, it is the idea behind all stock-picking: I think I see something others have missed. People able to do this consistently are rarer than baptized rattlesnakes. Which is also why those who have – Buffett — are so famous.

–At any given time there is so much information flowing around a company, both accurate and inaccurate, the idea that any outside individual is going to be able the hit upon insights not noticed by the legions of market watchers and professionals seems highly unlikely.

–The exception is, of course, if you happened to work for a company and learned new information that just came to light. Perhaps you were in the meetings where they gathered and are about to release proof that, contrary to rumor, their books are squeaky clean. But that would be insider trading and illegal.

All this said, if you want to give it a try with some of your cash go for it.

But be careful, especially if you enjoy some early success. It is very easy to confuse good luck with a new found skill.

Thank you for answering. I asked only because the idea could be summarized quickly and did not require you to read a book or blog, and your objections to talking about the investment strategies of others were based on doing so often taking a long time.

I have no intention of following that strategy; as I said I was sure there were problems with it. It takes a large amount of skill, luck, and effort to pull off, and the reward even if it did work is probably too small. I still think it could occasionally be possible, though; it’s basically a higher-effort, more-probable, lower-payoff version of “wait until there’s a flash crash and then buy cheap”. The difference between this and other strategies is that, as far as I can tell, bad luck with this strategy can be identified in advance (and thus results in not making a trade instead of making a bad trade).

Since the strategy is only relevant in the short term, the first two objections don’t apply as much; they’re about long-term trading. I completely agree with the semi-strong EMH in the long term, but am less convinced that all public information is at all times perfectly integrated in the short term. That would depend on the large majority of the shares of any given stock belonging to intelligent professional investors who are good at their jobs; the EMH depends on the market behaving rationally, which laypeople are not very good at (hence this post about most people losing money).

Bringing the discussion away from the specific strategy, I think if we ultimately disagree, the disagreement is over what percent of shares of any given company are owned by such professional investors instead of by the general public. The general public is large, so can be faster to integrate unexpected information, but probably does not do as good a job as professional investors. I would expect that in a lot of cases, laypeople can own enough stocks that the market does not react rationally to unexpected news and the professionals cannot fully make up the difference in the short term. Is there any good data on how much of the market belongs to professionals vs. laypeople?

I completely understand that “timing” the market tends to mean buying low and selling high, and that you have to be right twice.

But what about “timing” the market in terms of only buying low with no intention to sell? It’s hard to find much info on this relatively simple strategy.

We can pretty much count on the market to go down at least 5% a couple times per year. Why not wait until those down turns?

Just curious what you would say. I realize it adds a bit of complexity. And maybe it just doesn’t matter enough over the long term to make it worth it…

I’m pretty new to investing and finally started due to your website and how you broke it down in a way that made it simple enough to understand and therefore pull the trigger. Complexity is the enemy of execution…